California’s climate change initiative, AB 32, has weathered a few legal challenges over the past several months. Most recently a California court found that the California Air Resources Board (ARB) has authority under AB 32 to establish Offset Protocols, a set of rules that determine which carbon-reduction programs qualify for offset credits. The court also found that the protocols themselves were valid. However, not all of the challenges have run their course. For example, a state court case is still pending that challenges ARB’s authority to raise revenues through the cap-and-trade auction, and a federal appellate court has yet to issue a decision on whether the State’s low carbon fuel standard is constitutional. Nonetheless, the ruling on ARB’s offset protocols is significant because affirming ARB’s authority to regulate offset credits may create more certainty in California’s carbon market as ARB’s second carbon auction approaches later this month.

The challenge to ARB’s Offset Protocols, brought by Citizens Climate Lobby (CCL) and Our Children’s Earth Foundation against the California Air Resources Board (ARB), sought to invalidate ARB’s authority to set standards for determining whether greenhouse gas-reduction programs qualify for carbon offset credits. Offset credits may be purchased by entities subject to AB 32, such as power plants and manufacturers, and used as part of their compliance with the cap-and-trade program. An offset credit is also a tradable compliance instrument. Invalidation of those protocols would have had the potential to increase compliance costs for covered entities. San Francisco Superior Court Judge Ernest H. Goldsmith denied the challenge (January 25, 2013), preserving a vital component of the State’s climate change initiative to reduce greenhouse gas (GHG) emissions.  

Under AB 32, ARB must create regulations that drive power plants, manufacturers, and other industrial sources to reduce their GHG emissions to 1990 levels by 2020, a 17-percent reduction. The primary mechanism for achieving these reductions is a carbon auction system, the first of which occurred in November 2012. Under this system, known as cap-and-trade, covered entities have a cap on the amount of GHGs they can emit each year (which decreases annually). If an entity is under its limit, it has surplus allowances which it can save or trade. If an entity is over its limit, it must purchase allowances to cover its overage. Another way for an entity to cover its overage is to purchase offset credits from the developer of a qualified GHG-reduction program.

ARB determines which GHG-reduction programs will qualify for offset credits. ARB makes this determination through its Offset Protocols, a detailed set of requirements that include standardized methods for quantifying emission reductions from an offset project. There are currently four types of projects that can qualify for offset credits: (1) forestry/timber management; (2) urban forestry; (3) livestock operations, and, (4) destruction of ozone-depleting substances. An example of a qualified offset program is a methane aerator used at a livestock operation to reduce methane gas emissions. A covered entity can purchase and use offset credits to satisfy up to 8 percent of its compliance obligation. Offset credits may cost less than carbon allowances, reducing the overall cost of compliance for regulated entities.

In passing AB 32, the Legislature did not require ARB to implement an offset program. Indeed, the Legislature did not direct ARB to even implement the cap-and-trade system. Rather, the legislature set forth policy goals for GHG reductions, and directed ARB to implement regulations designed to reduce GHG emissions to 1990 levels by 2020. As the court noted in its decision, the Legislature gave ARB “vast discretion to develop regulations to curb GHG emissions.” However, AB 32 requires that GHG reductions are “in addition to any greenhouse gas emission reduction that otherwise would occur.” This “additionality” requirement is at the heart of CCL’s challenge.

CCL argued that ARB exceeded its regulatory authority by promulgating rules that allow for offsets that are not “in addition to any greenhouse gas emission reduction that otherwise would occur,” as required under AB 32. CCL contended the ARB can only determine which emissions reductions from GHG-reduction programs are truly “additional” by making a project-by-project assessment, rather than the standards-based approach implemented through ARB’s Offset Protocols. This standards-based approach, according to CCL, allows ARB to issue offset credits for projects that do not create additional reductions in greenhouse gas emissions.

“Additionality” is a significant component of any offset program from a policy standpoint, one that assures the offsets produce GHG reductions that help the overall cap-and-trade program achieve its emission-reduction goals. The Kyoto Protocol, for example, addresses the “additionality” problem through its Clean Development Mechanism (CDM). Under the CDM, a GHG-reduction program is “additional” if: (1) there is a barrier that prevents the proposed project, or (2) the proposed project is economically less attractive than another alternative, and (3) the proposed project is not typically deployed as a matter of common practice. The CDM tests, as Judge Goldsmith discussed in his decision, are the subject of heavy criticism for, among other things, not adequately determining whether a proposed project would, in fact, be additional. After reviewing shortcomings in the CDM, Judge Goldsmith found that “the factors which have rendered the CDM problematic in terms of administrative complexity, delay, and cost [are] highly persuasive in concluding that [ARB’s] rejection of the CDM’s project-by-project approach was justified programmatically and consistent with its legislative grant of discretion.”

CCL, however, scored one victory. Judge Goldsmith sided with CCL’s position that the Court should review the question of whether the Legislature granted ARB authority to use a standards-based approach to determine additionality under a de novo standard, rather than an arbitrary and capricious standard. However, the petitioner-friendly standard did not give CCL much more traction for its argument that promulgation of the Offset Protocols fell outside ARB’s delegated authority. For example, CCL argued that AB 32 prohibits the use of a standards-based approach because the law requires that “any” reduction be additional, construing “any” to mean that each and every offset project must actually have additional reductions in GHG emissions. CCL relied on a case holding that a ban on importing any product containing kangaroo meant a ban on each and every such product, not just those containing kangaroos protected by the Federal Endangered Species Act. In rejecting CCL’s argument, Judge Goldsmith took the liberty to analogize to the kangaroo case: “[T]he issue is not if some or all kangaroo products are banned; it is how to determine whether a product is from a kangaroo in the first place. While it is fairly simple to precisely determine whether a product is from a kangaroo, it is not as easy to precisely determine whether a reduction is additional.”

As for whether the Offset Protocols themselves were valid, the Court answered that question applying the arbitrary and capricious standard and resolved it in the affirmative. “The Court finds as to the Livestock Protocol, the Ozone Depleting Substances Protocol, the Urban Forests Protocol, and the U.S. Forests Protocol, that [ARB] has adequately considered all relevant factors and has demonstrated a rational connection between these factors, the policy implemented, and the purpose of the enabling statutes.”

Meanwhile, ARB is facing another legal challenge in Sacramento County Superior Court. On November 13, 2012, the California Chamber of Commerce filed suit against the Board challenging its authority to generate revenues through the cap-and-trade auction system. A hearing on the merits of the Chamber’s motion for writ of mandate is scheduled for May 31, 2013. Also still pending is a decision from the United States Court of Appeals for the Ninth District on whether the State’s low carbon fuel standard is constitutional (Rocky Mountain Farmers Union v. Goldstene). The appellate court heard oral arguments on October 16, 2012.

The next carbon auction is scheduled for February 19, 2013.